It’s What You Keep: Why Focusing on After-Tax Returns Matters

Maximizing after-tax returns should be the goal for assets in investors’ taxable accounts.

Maximizing pretax returns doesn’t necessarily translate into maximizing after-tax returns—and for investors’ taxable assets, it’s what remains after paying fees and taxes that really matters. This determines how much an investor can spend over time, give to charity and leave as a legacy for future generations.

But many investment strategies are designed to deliver the best risk-adjusted returns before taxes—not after investors pay taxes on their returns. For assets in taxable accounts, this distinction could make a dent in an investor’s ability to save for the long run. The good news? A growing number of strategies are being designed to maximize after-tax returns, which we believe provide a better fit for taxable assets.

Pretax Versus After-Tax Returns: A Closer Look

The difference between a strategy’s pretax returns and after-tax returns is largely driven by the level of tax expenses the strategy generates in managing its investments. Unfortunately, many strategies designed to improve pretax returns also increase tax expenses by just as much…or more.

The bond market provides a good example. On average, taxable bond portfolios have generated higher pretax returns over time than municipal bond portfolios (assuming equal duration and credit quality). But that top-line return advantage isn’t tax-free. The entire return carries a tax cost that has generally resulted in lower after-tax returns for investors subject to the top federal tax rate.

Let’s assume an investor considers two bond strategies for the fixed-income portion of a taxable portfolio (Display). The first invests in a broad range of taxable bonds, with a pretax yield of 4.80%. The second invests in a broad range of municipal bonds, with a 3.59% yield—but that yield is exempt from federal income taxes. Adjusting the muni strategy’s yield based on a 40.8% income-tax rate results in a pretax equivalent yield of 6.06%, much higher than that of the taxable bond strategy.

Based on this comparison, munis would seem like the better option by a wide margin. The story might be different if the assets were in a tax-advantaged account, such as a retirement account, where maximizing pretax returns makes sense. But when taxes are in play, after tax matters.

Changing the Approach: Managing Equities for After-Tax Returns

In balanced portfolios, equity exposure is a key counterpart to bond exposure. It provides a critical growth building block, and active management offers such portfolios the potential to outperform passive strategies. But maximizing after-tax performance, in our view, requires more-effective building blocks and a change in the way those building blocks are managed, including the critical dimension of capital gains.

First, it’s important to limit the taking of short-term capital gains, which are particularly costly for top-tax-bracket investors. This can be facilitated by holding short-term portfolio positions until they convert to long term positions. Second, reduce the total dollar value of capital gains realized by holding long-term positions as long as possible. And third, seek tax benefits by harvesting losses in other portfolio positions.

We think this “convert, reduce, harvest” approach (Display) can translate into a better tax profile. Of course, all these tax-management techniques should be evaluated through a lens that factors in tracking error versus a benchmark and other risk-management considerations.

The Growing Ranks of Tax-Efficient Investment Strategies

Investors with taxable assets want better after-tax returns, driving a boom in strategies and vehicles designed with that objective in mind. They include balanced direct indexing, which combines tax-efficient equity direct indexing and municipal bonds in a single separately managed account with a tax-management overlay.

Over time, we expect more products with tax-efficient overlays to emerge across both active and indexed strategies, producing a much more diverse universe of solutions for managing investors’ taxable assets. The specific approach to after-tax return generation can make a big difference, of course, so it pays to kick the tires on each strategy’s design and management when making the choice.

For investors who choose an effective strategy, it could be the solution to a taxing challenge.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. The views should not be considered to be, legal or tax advice. The tax rules are complicated, and their impact on a particular individual may differ depending on the individual’s specific circumstances. Views are subject to revision over time.